Wednesday, January 04, 2006

Loss Aversion

As I’ve said before, I’ve been blessed in many ways. One blessing is having financial security. I would have never guessed that I would become “comfortable” in life. My parents never had money. They could provide no guidance regarding investments or investing. However, one value they firmly imprinted in me was frugality. Growing up with little, it only takes a little to satisfy. I always had a bit of money left over at the end of each month, so I began to invest.

I’ve been investing in corporate stocks since my first job, more than 30 years ago. I made a lot of mistakes. I learned a great deal. Investing is a discipline that tests your intellect and your convictions. Over time, I believe I became a decent investor (of course, a 10-year bull run in the market helps enormously).

One of the hardest emotional barriers to good investing is “loss aversion.” Loss aversion is an all-too-human emotional response that compels us to continue with poor investment choices because we’ve invested so much in them and we simply can’t stand to think that the investment was wasted. This, then, leads to the “sunk cost fallacy” by which we throw even more resources down the drain rather than facing up to our mistakes and cutting our losses. Decisions about future investments should be made based solely on future possibilities, not biased by what may have been a huge investment in the past. I write this with the air of a know-it-all, but it comes from painful, personal experience. For example, I invested more than $80,000 in a company I had fallen in love with. I bought stock as the price was going up…way up…and then bought lots more as the stock came down…way, way down…all the way to bankruptcy. Yeah, loss aversion and the sunk cost fallacy can really hurt.

(Note: The sunk cost fallacy is also known as the "Concorde Effect", referring to the fact that the British and French governments continued to fund the joint development of the Concorde even after it became apparent that there was no longer an economic case for the plane. The project was widely regarded as a commercial disaster which should never have been started…and was almost cancelled…but political and legal issues ultimately made it impossible for either government to pull out)

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So, anyway, I was reviewing my portfolio recently, congratulating myself for some good decisions, and slapping myself upside the head for some poor choices. I always do a bit of pruning, rearranging and new investing about this time of year...and, therefore, I have to confront these two investing bugaboos again…

I paused to reflect on how difficult it is to shake off loss aversion. And we’re only talking money here, folks. Money’s not even that important. How much harder is it, then, to walk away from a failed relationship? Investing dollars is child’s play compared to investing your heart, guts, mind and soul in another human being. We bleed and cry for our relationships. We gnaw away at our own tough edges. We bite our tongues, bury dreams, sacrifice and suffer for the sake of love. We try so hard…and hope so much…that we can’t even recognize emotional bankruptcy until the pain completely overwhelms us.